Why CP Is A Train Wreck Waiting To Happen

| About: Canadian Pacific (CP)

It trades at 30 times earnings. It has a measly 0.8% dividend. It operates in a no growth business with a fixed capital base. It is run by a 68-year old CEO who is well past his best before date. It is being held responsible by the Quebec government for its lack of diligence in selecting the rail carrier that let loose an oil-laden train in Lac Megantic with a loss of 47 lives.

Investors can't seem to get enough of it.

The stock is running to all time highs, trading at $157 a share and putting a market capitalization of 30 times earnings on a business that might get to $6.6 billion of revenue next year if everything goes right. Nope, that revenue is not from software or services with a 90% gross margin, it is from a railroad. Yes, a railroad. A technology that peaked before any SA readers were born.

Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) all trade at less than 14 times earnings. Canadian Pacific Rail (NYSE:CP) trades at 30 times last year's earnings and 25 times this year's estimate. Go figure

Canadian Pacific is not building new railroads, adding capacity, acquiring new businesses, or inventing anything new or exciting. What it is doing is running trains faster, running longer trains, scrimping on maintenance and repair, jacking up prices and ramming lower pensions down the throats of its employees if they want to keep their jobs.

That is surely worth a high multiple of earnings.

Suppose CP had the ability to eliminate all labor costs and just operate with the cost of fuel and materials and necessary purchased services and rentals. It would still trade at almost 13 times earnings.

Canadian Pacific Railway Limited
2013 Estimate 2013 Pro Forma
Revenue $ 6,083 $ 6,083
Fuel $ 975 $ 975
Materials $ 243 $ 243
Purchased services $ 900 $ 900
$ 2,118 $ 2,118
Margin $ 3,965 $ 3,965
Compensation $ 1,460 Nil
Equipment rental $ 184 $ 184
EBITDA $ 2,321 $ 3,781
Depreciation $ 542 $ 542
EBIT $ 1,779 $ 3,239
Interest and fx $ 294 $ 294
EBT $ 1,485 $ 2,945
Income tax $ 386 $ 766
Net income $ 1,099 $ 2,179
Earnings per share $ 6.28 $ 12.45
Share price $ 157.00 $ 157.00
Price to earnings 25.0 12.6

It is pretty obvious that even the famed Hunter Harrison can't reduce employee compensation to zero (try as he might and with the exception of his own) and while there are some short term tailwinds that will allow CP to post pretty good results (shortages of rail capacity for grain, bottlenecks in oil transportation) based on temporarily higher freight prices, customers have long memories and things pretty well always come back to normal.

In the meantime, CP can complain about its fairness but the Government of Quebec has ordered them to pay for some of the cleanup of Lac Megantic. Lawsuits have been filed, and the concept CP seems to espouse that you can put hazardous cargo in the hands of a third party without adequate due diligence on their ability to handle it is likely one in which CP will find Quebec courts less than sympathetic.

At the same time, the spate of derailments of CP trains triggered by Harrison's ruthless cost cutting and aggressive management of preventive maintenance, train lengths and speeds in an atmosphere of fear will eventually catch up to the company. I hope it does so before any more lives are lost.

CP Rail today represents most of what is wrong with North American business "activists" who think they know better. Oust a blue chip board of directors, install a reckless and mercenary CEO with a short term agenda, destroy a few careers, humble organized labour, take risks with train length and train speed, and contribute to a few dozen deaths. All in the name of making a hedge fund a short term gain. Good for Bill Ackman, he has made a lot of money for his investors and now he is cashing out. What he leaves behind is not pretty.

What goes around comes around. Ackman's activist involvement with J.C. Penney (NYSE:JCP) and Herbalife (NYSE:HLF) show stirring the pot sometimes pinches.

Herbalife seems to have fended off the charade, but JC Penney has been damaged by Ackman's intrusion. And as far as CP goes, it will survive and be profitable but the legacy of people hurt by the exercise will leave a bad taste for years to come.

At the end of the day, CP is a railway. It is overvalued by half. I am short the stock.

Disclosure: I am short CP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.